[The following guest post is contributed by Abhilasha Mondal, a 5th year student at the National Law School of India University, Bangalore. She can be contacted at firstname.lastname@example.org.]
The Finance Bill, 2015-16, actualises the merger between the Securities and Exchange Board of India ("SEBI") and the Forward Markets Commission ("FMC"). The unification of the regulators, that has been previously recommended in the Report of the Inter-Ministerial Task Force on Convergence of Securities and Commodity Derivative Markets (2003), the Percy Mistry Committee Report (2007), the Raghuram Rajan Committee Report (2009) and the Financial Sector Legislative Reforms Commission Report (2013), will finally materialize once the Bill has been passed by the Parliament.
Parts II Part III of the Finance Bill aim to give effect to the merger, by introducing amendments to the respective statutes governing the securities market and the commodity derivatives markets.
By an amendment to the Forward Contracts (Regulation) Act, 1952 ("FCRA"), a new savings clause by way of section 28A has been introduced which states that all recognised associations under the FCRA shall be deemed to be recognised stock exchanges under the Securities Contracts (Regulation) Act, 1956, ("SCRA"). SEBI will give these exchanges adequate time to comply with the SCRA. The amendment also provides for the repeal of the FCRA and all the rules and regulations framed, and the dissolution of all bodies established thereunder. All fresh proceedings with respect to the offences under the FCRA will be initiated before SEBI.
Under the SCRA, the Bill will amend the definition of securities under Section 2(ac) to include commodity derivatives and forward trading within its ambit. Additionally, an amendment to Section 18A will empower the Central Government to notify certain contracts as derivatives.
In effect, the securities market regulator, SEBI will now supervise all regional and national commodity exchanges. The guidelines issued by the FMC will remain in effect for a period of one year or till its merger with SEBI, whichever is earlier.
Market experts believe that regulation of commodity derivatives trading requires specialized knowledge for the reason that factors affecting commodity prices are highly complex and commodity specific. The Report of the Inter-Ministerial Task Force on Convergence of Securities and Commodity Derivative Markets lists out some of these divergences between the securities market and the commodities markets.
Firstly, financial futures are actively traded in cash markets, due to which its cash prices are usually not discoverable in the futures market. Future contracts, instead, are generally settled from cash or indexes of cash price. The delivery and settlement processes among the two segments differ significantly. Exchanges monitor contract expiration, set the terms of delivery, oversee physical delivery and credit verification of members, and provide financial services such as clearing, delivery, margining and trading. However, in derivatives transactions, delivery and oversight is less significant, and it can be substituted by cash transactions and other institutional arrangements.
Secondly, it is feared that segments such as agricultural commodities would lose focus in the enormous web of financial products that fall under the securities exchanges. Willing participants feel the impact of price volatility in the stock markets, as opposed to in the commodities market, where the impact of price volatility is felt across the country due to the sharp fluctuation in the respective commodities’ prices. The utmost priority of the policy makers must be to safeguard the interests of the farmers and consumers.
Thirdly, removing restrictions on the integration of the two markets may have adverse impacts on the viability of smaller exchanges that have been recently granted in principle approval. These exchanges, which have incurred massive investment expenses on infrastructure, may not be able to penetrate the commodities segment immediately, once the amendment is in effect. The larger exchanges will be able to benefit from these regulatory changes due to their economies of scale.
Approaches to Integration
Presently, Regulation 8 of the Securities Contracts (Regulation) Rules, 1957 ("SCRR") restricts stock-brokers to operate simultaneously in the commodity markets and securities markets. To overcome this restriction, a stock-broking entity will have to set up a separate and independent entity that can be registered to function under the commodity exchange. Both these entities will be required to comply with the regulatory prescriptions on capital adequacy, margins, membership, net worth, etc. of their respective regulators and exchanges. The rationale behind the requirement of independent entities is to ensure that risk in one market does not have a cascading effect on other markets. The prevention of systemic risk, in case of failure in one segment, is the root of this regulation.
The Report of the Inter-Ministerial Task Force provided a brief description of the various models for the integration of the securities market and the commodity derivatives market. One of the models described was Integration at the Level of Brokerage Firms, which deals with the possibility of brokers to operate, simultaneously, in the commodities as well as the securities markets. The Bill, that will now permit exchanges to trade in both commodity derivatives and securities, will have the effect of permitting brokers to trade in both the products simultaneously, without having to set up two independent entities.
Implications of the Merger
The SEBI-FMC merger has implications from an economic and a regulatory standpoint. The economic advantages of the merger include the fungibility of exchanges and intermediaries to penetrate into each other's market segments. This fungibility is expected to improve the overall quality of institutions and intermediaries, promote competition, increase returns at low incremental costs, provide greater choice in investments to investors, and enhance liquidity in the markets. The merger sounds a death knell for dabba-trading activities, which are illegal off-market trades, which are said to generate a turnover of around 1 lakh crore in a day. Trading volumes in commodity markets are also expected to increase due to the boost in investor confidence, because of the substitution of the extant framework with that of SEBI's discerningly effective regulatory presence.
Although the SEBI-FMC merger has elicited much market euphoria, a plethora of new-fangled concerns regarding the regulation of commodity derivatives have surfaced. SEBI presently does not have the specialized knowledge or expertise to supervise and monitor the commodities market. Unlike the deliveries of bonds and shares, the deliveries of commodities are physical in nature. When the merger was previously proposed in 2009, the then FMC Chairman, B.C. Khatua had commented on the impracticality of the same, because he believed that the motivations driving the two regulators were different. SEBI played a pure regulatory role, whereas the market conditions of the commodity derivatives were such, that the FMC had grown undertake more of a developer-cum-regulator role. The task of SEBI was to mobilize capital for investment, while on the other hand the FMC was in charge of managing price risk and price discovery. The merger would thus have a diluting effect on the commodities market.
Khatua also pointed out that at par regulatory treatment of commodity derivatives and securities had backfired in the West, and could pose dangers in the commodities market. The sharp increase in crude oil future prices had transcended onto the price of the underlying commodities, which had resulted in the destabilizing of the global economy in 2009.
Markets experts anticipate the emergence of new products with the bringing of commodity derivatives under the definition of securities. Investors might now be able to subscribe for instruments such as commodity options and commodity indices that were previously not offered. There is much speculation whether fund houses will be permitted to launch commodity funds. Additionally, subject to the approval of the Central Government, sports, weather or freight derivatives may be introduced in the markets.
It is imperative at this stage to acknowledge all these issues that will materialise at the instance of the merger. To address the above mentioned challenges, SEBI will have to issue regulations, guidelines or clarifications with respect to the regulation of commodity derivatives, and plug the plausible loopholes with respect to new financial products that may see the light of day, to ensure that such products do not escape regulatory oversight.
Ancillary to the regulatory impediments, an administrative decision will have to be taken as to whether SEBI must alter its organizational and regulatory framework and create a separate segment for commodity derivatives, or whether the regulatory prescriptions applicable to securities will now be extended to commodities derivatives with appropriate exceptions.
Besides the regulatory and administrative concerns, the economic argument against the merger is the increased risk factor in affording integration of markets at the level of brokerage firms. Subsequent to the merger, securities exchanges and commodities exchanges will have the fungibility to penetrate into each other's markets. This denotes that a commodity exchange can facilitate currency derivatives or equity trading, whereas a securities exchange will now be permitted to launch commodity trading. The same fungibility will be afforded between clearing corporations and depositories. Therefore a stock-broker does not have to set up a separate entity to trade in commodity derivatives. As discussed earlier, the rationale behind Regulation 8 of the SCRR was risk containment and minimizing the possibility of systemic risk across the markets. After the merger, the collapse of a systemically important broker in one market might send shock waves in all those market segments in which that broker has a presence.
The dynamics of the commodities market will have to be studied in depth by the securities regulator to grasp the nuances of the sector. SEBI has a long way to go in the time window imposed by the Central Government, and must bring clarity in the regulatory environment, which is vital to the success and stability of Indian capital markets.
- Abhilasha Mondal